What Ben Bernanke May Be Thinking

There has been a firestorm of criticism of Federal Reserve Chairman Ben Bernanke’s new monetary easing initiative, and much speculation as to why he did it. I want to suggest—to paraphrase Mark Twain—that Mr. Bernanke is worried that rumors of the of death of the Great Recession have been greatly exaggerated.

In both the Depression and the post-World War II era, recovery from a recession has been regularly signaled by an increase in housing investment. But new housing construction expenditures have remained stubbornly flat since the Great Recession was declared over in the second quarter of 2009.

Housing and aggregate demand have not recovered because nearly 15 million owners are estimated to owe about $771 billion more on their homes than they are worth. The banks are on the other side of this crunch, holding overvalued mortgage assets. This fuels doubt about the balance sheets of the big banks.

Consider what happened during the Great Depression. Housing investment plummeted steadily from 1926 to 1933. New housing expenditures started to recover in 1934, buoyed perhaps by Congress’s creation of the Home Owners Loan Corporation (HOLC). This agency bought underwater home mortgages and reissued them at values that were based on prevailing home prices.

This experience was not forgotten: In September 2008, then-Sen. Hillary Clinton proposed reviving HOLC, and Sen. John McCain offered the same proposal in the second presidential debate of October 2008. This fledgling bipartisan movement failed to attain traction.

Yet both proposals recognized an important principle: A solution to the negative-equity problem in the housing market would also reboot bank balance sheets and enable new lending to be resumed. By implication it would allow home prices to return to their long-lost equilibrium. Three birds with one stone.

Instead, a revival of HOLC lost out to the hoopla of a trillion dollars in blunderbuss stimulus spending and new subsidies to new home buyers to prop up declining home prices.

That has not worked very well. But QE2 just might work if it is implemented as a surgical strike at the still-unresolved problems of negative equity in housing and banks. Mr. Bernanke’s first round of quantitative easing in 2008-09 lifted about $1.2 trillion of shaky assets off the balance sheets of banks, replacing them with nearly a trillion dollars in excess reserve deposits. The second round will further expand these deposits.

So perhaps the Bernanke message here is for the banks to deploy those excess reserves to reset the value of their loan assets to current housing prices. They could do so by issuing new mortgages with lower principal amounts. While they would take short-term losses, this action could allay doubts about the value of the assets on bank balance sheets and would help the balance sheets of homeowners as well.

Is this what Mr. Bernanke is thinking? The rollout of QE2 was coupled with a Nov. 17 Fed announcement requiring the large banks to undergo another review of their capital and ability to absorb losses.